The Krugman Illustration

The above diagram appeared in this Krugman article: “Austerity and Growth“ – Paul Krugman, The Conscience of a Liberal, New York Times, 2/18/2012

Like a true genius, Krugman’s diagram lacks beauty and is a bit cryptic… it looks sorta like scribbling on the back of an electronic, Excel-based envelope.

The X-axis plots the change in real government purchases of goods and services from Q1 of 2008 to Q4 of 2011… a period of four years. Q1 of 2008 was just before Europe slipped into recession. The negative numbers on the left mean there was REDUCED government spending at the end of the four years. That defines “austerity”.

The Y-axis plots the percentage change in real GDP over the same period of time. The positive numbers at the top are the percentages of growth. The negative numbers at the bottom are the percentages of GDP reduction. GDP is a measure of the total economic output of a country.

The dots are various European countries. The dots at the bottom are countries whose economies shrank. The dots on top are countries whose economies grew. The dots on the right are countries whose governments spent more money.

The dots on the left are those dastardly countries who practiced austerity!

Krugman identified four countries: Latvia, Ireland, Greece and Poland. Poland’s government, for example, spent a lot more money and had the most economic growth. Latvia had the most spending cuts and had the most GDP shrinkage. (think Seinfeld!)

It proves austerity stifles growth, right? No, it doesn’t.

Austerity and Growth

Krugman is correct that there is a loose positive relationship between government spending and real GDP growth. That is clear from the points on the picture. He is also right to warn against reading to much into it’s apparent upward slope.

The $64,000 dollar question, though, is this:Does more government spending trigger economic growth, as Krugman says, or does economic growth trigger more government spending?

The Krugman picture supports both possibilities.

Austerity Ain’t The Whole Story

What is also obvious from the picture above is that austerity alone cannot explain what we see.

Greece’s real GDP shrank just as much as Latvia’s, yet Latvia cut spending five times as much as Greece. Why didn’t Latvia’s real GDP shrink five times as much? Heck, one unidentified country reduced spending twice as much as Greece yet still had POSITIVE real GDP growth!

On the government spending side, three countries outspent Poland, yet two of their real GDPs actually SHRANK!! Why didn’t they grow as Krugman says they should?

The Alternative

At best, austerity is only loosely linked to economic decline. The very wide scattering in the points is proof of that. If government austerity were the primary determining factor of economy decline than the scatter of the points would be much narrower and make more sense.

The very wide scattering suggests there might be another possibility.

The private-sector is the main driver of economic growth, not government spending. Its logical that some countries, like Poland, spend more because they had more growth, and therefore had more to spend and could afford it. Other countries spend less because they had less to spend and could not afford it.

Other factors that complicate the GDP situation are external trade, geopolitical activity and other stuff. Those have affected Europe greatly the last few years.

Non-austerity factors explain why the country points have such a wide non-causal scatter.

What is interesting about the Romer graphic is it plots military spending (not total government spending) vs. economic output.

Based on the larger apparent upward slope of scatter points, it suggest that if there is a relationship between government spending and economic growth at all, then military spending has a greater effect!

Conservative Republican economists would have a field day with Krugman and progressive Democrats over that.

They would argue, of course, that spending on expensive social programs drags down an economy and that military spending returns more bang for the buck.

Conclusions

Though Krugman’s counter-cyclical fiscal policy approach can and has worked before, Europe’s debt is so great this time that it might counterbalance the effect, if any, of spending to the point it is rendered ineffective.

Private-sector economic growth, mostly driven by small businesses, always has and always will be the primary driver of a country’s economic growth.

Though Krugman’s diagram shows a loose relationship between government spending and real GDP growth he only assumes a causal relationship. The opposite – that GDP growth causes government spending – is the more logical causal relationship.

Bottom line… Given it’s massive debt, austerity may be Europe’s only reasonable choice to avoid recession or worse. Europe seems to think so.

Your final comment intrigues me – how do you know if it’s the small or large businesses which drive growth, and how do you make your policies beneficial for small and not large businesses? (I say “and not” assuming that the large businesses increasingly monopolise and therefore what is good for them is bad for small business).